Can the observed differential be explained?

The annual retail price differentials with independent UK dealers were estimated at 2.76–3.90 ppl for unleaded and 2.3–3.9 ppl for diesel. The average differential for both fuels was estimated at 2.98 ppl (diesel) – 3.27 ppl (unleaded).39 _{Some of this difference} can be explained by higher costs of operating in the Isle of Man as outlined in Table 16:

39 _{The monthly differential with UK dealer average is significantly volatile – ranging between -2.4 – 12.4}

Table 16 – Explaining the road fuel price differentials, ppl

Average differential with UK dealer owned sites 3.0 – 3.3

Readily quantifiable cost differences 1.0 – 2.3

 cost of importation and shipping to the Island 0.8 – 1.5

 smaller scale of operation (smaller tanker sizes) 0.3 – 0.8

Potential cost differences 0.5 – 1.0

 lack of wholesale product competition (higher uplift relative to the benchmark cost and uplift charges for other sub-markets in the UK)

 limited competition compared to the UK (lack of a

‗supermarket effect‘) 0.5 – 1.0

Qualitative cost differences

 low profitability of UK distribution (and/or higher on-Island distribution costs)

 higher fixed cost of operation (cost of operating two storage terminals and piers)

 diseconomies of scale from lack of support services and specialist contractors

The costs summarised in Table 16, are outlined in detail below and include:

 the cost of importation and shipping to the Island adds 0.76 - 1.45 ppl to the cost;

 limited competition compared to the UK – though the throughput implications have been accounted for by comparing with a dealer-owned site, the additional impact on all market participants in the UK of the nature of retail market

competition with the inclusion of the supermarkets has not been accounted for. Without the prospect of this pressure, average margins may be higher. It is hard to quantify this difference robustly. Indicative calculations suggest that, without supermarket competition, average margins in the UK might be in the order of 0.5 ppl to 1 ppl higher;

 lack of wholesale product competition – the extent of the uplift on ARA prices applied to Isle of Man imports may be higher than that in the UK. The current uplifts are 0.73 ppl for unleaded and 2.54 ppl for diesel. Though it is not expected that all of this is an additional Island cost, a proportion may be;

 smaller scale of operation – the average road tanker size in the UK is 36,000 litres, whereas the largest used for Isle of Man deliveries is 23,000 litres. Even in the Island, there are small load premia for lower volume deliveries, so there is expected to be a differential with average UK delivery costs.

 higher unit fixed costs specific to the Island - costs such as the cost of operating two storage terminals and piers and the costs for inventory holdings due to delivery cycle contribute to the increased costs of supplying road fuels in the Island;

 higher costs due to lack of support services and specialist contractors forcing local market actors to invest in developing capabilities that are infrequently used or would be more cheaply sourced in a larger market or importing services and personnel from the UK (such as, for example, lack of part time road tanker drivers);

 the wholesale business in the UK is not very profitable - the UK OFT study in 2000 indicated that it earned no profit – a conclusion supported by the 2008 Highlands and Islands report which estimates that the average profit is 0.4 ppl. Thus, some additional return would be necessary to sustain the current

distribution network in the UK. The higher margins would need to be reflected in higher overall returns than those necessary to sustain a stand alone business. The combined cost of small scale operation (described above) and higher distribution costs on-Island is estimated to account for a combined total of 0.26- 0.8 ppl of the differential. 40

Thus, between 1.5 ppl and 3.3 ppl of the average differential can be explained by direct cost and market size differences. However, this still leaves up to 1.8 ppl without a readily quantifiable explanation.41 _{Whilst several drivers of the elements of higher costs} have been noted above, it has not been possible to determine whether or not they account for the remaining difference, although it is expected, however they will account for at least a proportion of the remaining differentials.

3.6

Summary

Having reviewed the costs and margins in the road fuels market the main conclusions are as follows:

 wholesale margins remained relatively stable for unleaded but were high for diesel, however adjusting for the higher cost of product for diesel implies constant margins for the period relative to 2006 findings;

 retail margins were relatively stable, but do not appear to be unreasonable given the size of the market and the fixed costs associated with operating a filling station;

 the differential with UK average prices has decreased in recent times, however, in general the level of the differential has been of the order of 5 ppl against UK average prices and 2 – 4 ppl relative to UK dealer - owned sites;

 Up to 1.8 ppl of the differential with the UK is unexplained by direct cost, market structure or competition issues, however other unquantified cost drivers were highlighted that may partly explain the residual differential.

40 _{The estimates are based on views relating to the impact of economies of scale across distribution}

activities in the UK.